A Subtle Difference

Posted on January 9, 2017

"The only value of stock forecasters is to make fortune-tellers look good."– Warren Buffett

In our last post entitled An Alternative To Buy-And-Hold we argued that a buy-and-hold investment strategy shouldn’t be thought of as a one-size-fits-all solution for every investor. Now there is nothing inherently wrong with a buy-and-hold strategy as long as it is a good fit on both a time horizon and psychological basis for the investor trying to practice it. Since this is not the case for everyone, we offered up our preferred investment discipline of trend following as a potential alternative. Sometimes when we talk about the discipline of trend following with people who are unfamiliar with it, we get asked the question of whether “trend following is a form of market timing.” In this week’s post we will explore this question and unpack why there are subtle, yet very import differences between a trend following investment discipline and what traditionally has been thought of as a market timing strategy.

The first thing we need to do is clearly define what the phrase market timing really means. For some it may mean any investment strategy with a buy and a sell discipline. But under that strict definition pretty much every investment strategy would be considered market timing. The only strategy that wouldn’t fall under this definition would be one where investments were bought but never sold. As such, a more appropriate definition of market timing is any strategy that makes buy and sell decisions based on a prediction of the future.

The human brain is very linear in how it processes information. We want to understand the cause to every effect. This is why on any given day you can turn on the financial news and hear statements such as “the stock market is up/down [some amount] today, because of [some cause].” Our brains crave linear explanations, which is why so many people make predictions about the future based on their logic, research, and good old intuition (e.g. gut-feel). But unfortunately, we all live in a very non-linear world and as such, predictions about the future are often wrong or worse yet, sometimes correct which gives an individual an unfounded confidence in their ability to continue predicting the future as we wrote about in The Power of Prediction. This is why market timing has such a bad rap when it comes to investing, and rightfully so as any “strategy” that relies on predicting the future is destined to fail.

So now we get back to our original question on whether trend followingis the same as market timing. The short answer is no and here’s why. Unlike market timing, trend following is entirely reactionary and is not trying to predict the future. A typical trend following discipline measures changes in price over some period of time (weeks, months, years) and then makes a buy or sell decision based on the positive or negative historical trend. The big difference here is that trend following is reactionary (looks at the past) and rules based rather than predictive (guessing about the future) in nature.

The difference may seem subtle but it is extremely important. For example, no one would consider value investing to be market timing because it makes no prediction about the future. It simply makes a judgement call about whether an investment is cheap or expensive and buys or sells in accordance with that judgement. The value investor doesn’t know how long it will take for his/her cheap stock to be fairly priced or even expensive in order to trigger a sale, because they aren’t trying to predict the future. The same is true for trend following, the only difference is that the buy and sell decisions are being driven by different signals (momentum vs. value).

Eugene Fama and Kenneth French are two very well-known (in some circles) economists best known for their early work on the efficient market hypothesis. The efficient market theory proposed that the return of any single stock could be explained by the amount of risk and correlation (beta) that stock had to the overall market. Over the years, Fama and French realized that this conclusion was oversimplified and that there were a number of “anomalies” that led to higher returns without higher levels of risk including different factors such as value, quality, size (small cap vs. large cap), momentum, and others. This realization gave rise to what is now known as factor investing. One of Professor Fama’s former students named Cliff Asness, who is a huge proponent of trend following, founded AQR Capital on the principle of factor investing. After almost two decades of success, which included two major stock market sell-offs, AQR now manages over 170 billion in capital.

In conclusion, trend following is a reactionary investment discipline which isn’t trying to predict the future. In the same way that value investing shouldn’t be considered a form of market timing, nor should trend following or momentum investing. Perhaps the best way to understand the difference between trend following and market timing is through the example of a stop light. When the trend follower comes to an intersection, he/she simply obeys the stop light’s instructions. If it is red, they stop (going to cash for MarketVANE). If it is green, they hit the gas and go (fully invested for MarketVANE). In contrast, when the market timer comes to an intersection they may slow down when they see a green light or “jump the light” on a red signal in anticipation of the lights changing. On discipline is reactionary, while the other is predictive. The difference is subtle, but makes all the difference in the world.

Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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